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The Saudi’s Con Game

This article originally appeared on National Review Online
on May 14, 2002.

Saudi Crown Prince Abdullah’s recent visit to the Bush ranch and
the leaked Saudi threat of turning the oil weapon against America
prompted politicians and pundits to worry about whether our
“special relationship” with the House of Saud could survive the
ongoing violence in the Middle East and about the catastrophic
consequences that might accrue if it didn’t. This “special
relationship,” however, is a self-serving fiction that has governed
American foreign policy for far too long. In short, the Saudi
regime has pursued a policy of economic predation and political
blackmail for as long as they’ve dominated world oil markets.

A review of that record is long overdue. In 1967, for instance,
Saudi Arabia led an ineffectual oil embargo against the United
States to protest our support for Israel in the Six Day War. In
1971, the Saudis again threatened an embargo lest the consuming
nations accepted massive new OPEC production taxes, a levy codified
in the so-called “Tehran Agreement” that began the long march
towards higher prices. The agreement, which was supposed to last
five years, was effectively torn up after only six months once the
Saudis realized that they could extort more money from the
consuming nations. In early 1973, Saudi oil minister Sheik Yamani
on two occasions threatened “economic war,” warning that
“industries and civilizations would collapse” if consuming nations
tried to fight further OPEC’s price increases.

Even though the West complied, the Saudis took the lead in
organizing the 1973 oil embargo and production cutbacks, sending
oil prices from $2 a barrel to $7. In 1974, despite promises to the
contrary, they initiated another round of production cutbacks and
tax hikes, sending oil prices to $11 a barrel. In 1975, King Faisal
again threatened a crisis “far more severe than the last one”
unless the Israelis withdrew from Arab lands.

In 1978, OPEC, under Sheik Yamani’s direction, quietly
established a goal of raising the price of crude oil to just below
the cost of producing synthetic liquid fuels, which suggested a
price of $60 a barrel (a whopping $136 in today’s terms). They
began their campaign in January 1979 when a series of Saudi
production cutbacks set-off the second price explosion, culminating
in prices at $34 a barrel ($60 a barrel in today’s money) by
October 1981. The only reason that crude oil prices never reached
the levels dreamed of by our Saudi “friends” was the advent of
independent oil commodity markets (particularly futures markets)
and, in the words of the Kuwaiti oil minister at the time, because
of “a consistent underestimation of potential supply and a
consistent underestimation of the consumers’ ability to adjust
their demand … led OPEC to overestimate their strength.”

After desperate Saudi attempts to stave-off collapse failed,
Vice President George Bush traveled to Riyadh in 1986 to implore
the Saudis to arrest the price slide because - I kid you not - the
administration feared the effect of cheap oil on the world economy.
Since by this time the Saudis were feeding the collapse in order to
inflict pain on competitors who needed a lesson in production
discipline, they naturally responded to Bush’s pleas by …
increasing output still more.

Once the price war was over the Saudis encouraged Iraq to put
the screws to Kuwait to punish that country’s history of
cartel-breaking overproduction. Only when “the enforcer turned
robber,” according to MIT professor Morry Adelman, did Saudi Arabia
reverse course and call for Western intervention. But even then the
Saudis fed the resulting price spike by refusing to increase
production for over a month. Their refusal to fully tap their
excess production capacity prolonged the economic damage.

Which brings us to another oft heard argument, that Saudi
Arabia’s policy of not producing near as much oil as it could is in
our best interest because untapped production capacity serves to
stabilize oil prices. While it’s generally good for consumers when
spare capacity can be tapped in the event of unforeseen market
dislocations, the Saudis have never used their excess capacity for
that purpose. Instead, the Saudis use that excess capacity to
discipline - and thus, to empower - OPEC.

Cartel watchers realize that excess production capacity is
absolutely necessary to sustain bargaining power within OPEC.
Without the ready Saudi threat of flooding the market, cartel
members would have an almost irresistible incentive to cheat on
their agreed-upon production limits. Accordingly, spare Saudi
production capacity is the main thing that keeps the OPEC cartel
afloat and international price wars over oil from starting.

So, does a well-functioning cartel really serve to stabilize
prices? In the past several years world oil prices have bounced
around between $10 and $35 a barrel, which doesn’t suggest a great
deal of stability. In fact, the cartel makes prices more unstable
than they otherwise would be. That’s because higher prices and
higher revenues enable cartel members to withstand financial
pressure to cheat on their production quotas, which promotes still
higher prices. Lower prices, on the other hand, strengthen the need
for cash, which weakens the resistance to quota cheating and
promotes still lower prices. Thus, market movement in either
direction tends to speed-up-not slow-down-the velocity of price
movement, making markets less rather than more stable. Indeed, the
oil price explosions faced over the past 30 years have been
unrelated to scarcity and entirely due to the cartel.

Summarizing the record of the past 30 years, Adelman concluded
in his magisterial book Genie Out of the Bottle: World Oil
Since 1970, “we look in vain for an example of a government
that deliberately avoids a higher income. The self-serving
declaration of an interested party is not evidence.” OPEC’s long
record of huffing-and-puffing over Israel - and related promises of
more oil in exchange for support of the Palestinian cause - has
simply served as a useful cover for production decisions that would
have been made regardless. But if the West thinks that crossing
Persian Gulf suppliers will result in economic retaliation - or
that reduced support for Israel will translate into lower oil
prices - so much the better from the Saudi perspective. That
policymakers have never noticed the lack of relationship between
American foreign policy in the Middle East and Saudi oil-production
decisions is a mystery to me.

The bottom line is that the Saudis, no matter what they might
like us to believe, are not doing us any favors by selling us oil
at $24 a barrel that, without the collusion, would probably go for
no more than a third of that. Threats that the Saudis might turn
hostile if we don’t change course in the Middle East are laughable
- they went hostile a long time ago.